Q: I've had your "Couch Potato" portfolio for my 403(b) account for close to five years, with 60 percent Vanguard Total Stock Market index...
Q: I’ve had your “Couch Potato” portfolio for my 403(b) account for close to five years, with 60 percent Vanguard Total Stock Market index fund and 40 percent Total Bond Market index.
You now suggest inflation-protected securities in place of the Total Bond index. Can you tell me why the change? Would it be wise for me to swap out (having accumulated quite a bit of shares in the Total Bond), or is this what you recommend for those starting a new portfolio?
— M.F., Jacksonville, Fla.
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A: Choosing between Vanguard Total Bond Index fund (or its clones from other fund companies) and an inflation-protected securities fund is a pretty close call. But let me tell you why I think TIPS are likely to be the superior investment. (TIPS stands for Treasury inflation-protected securities.)
The Vanguard Total Bond Index fund is an “intermediate-term” government fund. If it follows the history of intermediate government securities, as tracked by Ibbotson Associates in Chicago, it will provide about a 3 percentage point premium to inflation, less its expenses of no more than 0.20 percent.
Unfortunately, it won’t be a steady 3 percentage point premium. With conventional bonds, interest rates tend to rise with inflation. Rising interest rates cause bond prices to decline.
In 1994, for instance, interest rates rose dramatically. As a consequence, Vanguard Total Bond Index had an interest return of 6.37 percent — but lost 9.03 percent in market value of the bonds. Result: a net loss of 2.66 percent for the year.
Rising interest rates would have a similar effect on inflation-protected securities — unless rising inflation was the cause of rising interest rates. If inflation was rising, the yield on inflation-protected bonds would rise. This would offset some of the damage of rising interest rates.
TIPS could be even better investments if we have another period of roaring inflation like the ’70s. Then, investors would be likely to sell conventional bonds and buy TIPS simply for inflation protection. As a result, the price of TIPS might actually rise.
Basically, the inflation-adjustment element of TIPS makes them likely to do better than conventional bonds in an environment of rising interest rates.
While American Century, Fidelity, PIMCO and Vanguard all have managed funds that invest in real return securities, it is also possible to buy an exchange-traded fund (ETF) based on the Lehman Brothers U.S. TIPS index. It’s the I Shares Lehman TIPS (ticker: TIP), and it has an expense ratio of 0.20 percent.
Questions about personal finance and investments may be sent to Scott Burns at The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; by fax at 214-977-8776; or by e-mail at email@example.com.
Questions of general interest will be answered in future columns.